Do accountants stifle innovation?

In an April 2011 article, the Institute of Chartered Accountants bragged that “A remarkable 32% of the chief executives of the JSE’s top 194 companies ranked by market capitalisation are chartered accountants”. With South Africa having dropped 16 places in the World Innovation Index from 2011 to 2012, this may not be a good thing!

There is evidence to suggest that traditional accounting procedures may stifle innovation in organisations

An Australian study of executives from over 100 biotech companies asked how financial criteria were used to select innovation projects. The survey revealed that the organisations essentially use two styles of innovation planning.

The authors collected and analyzed data which revealed that traditional accounting and valuation methods damage innovation performance. The main conclusion was that there needs to be a different kind of accounting to manage the innovation process. In particular it’s the project selection step where planning and valuation methods can make or break innovation.

The traditionalists used best estimates of market size, cash flows and chances of success to arrive at a value of the project. This style is closely aligned to net present value analysis.

The other group placed less emphasis on prediction and valuations and were prepared to stage investments in the project. As the project showed promise (or not) funding would be increased or discontinued. In finance terms, these were the ‘real options’ managers. Like a stock option, they were prepared to ride the uncertainty by taking an initial stake in the upside but also recognized that options are valuable because they limit how much will be lost if the project doesn’t perform after the early stages of development.

When these financial management orientations to innovation performance were measured (by number of patents, which is valid in biotech) the first result was unsurprising. Real-options management was positively and significantly correlated with innovation. However, the second result was a bit unexpected.

The traditionalists using mainstream planning approaches (NPV managers) were negatively correlated with innovation performance. In other words, imposing strong traditional financial criteria for project selection made the company less innovative than those that had no particular financial criteria for the selection of projects!

This leaves three possible takeouts for managing innovation:

Innovation means trying things out and failing. Attempting to provide detailed plans and forecasts regarding what is going to work will mean missed opportunities.

Large organisations with traditional planning processes and valuation tools need to create different procedures for managing innovation.

There needs to be a change in the way innovation projects are valued that include the upside of uncertainty in the assessment. While there is a focus on the downside risks with innovation projects, companies should consider that risk has an upside too. Risk reduces the value of businesses in traditional valuation tools.

The research paper was written with Mat Hayward, Andrew Caldwell and Peter Liesch.